Many small business owners use cash accounting instead of accrual accounting. In addition, they often run a number of personal expenses through their companies or ratchet up their contributions to company retirement accounts to increase their retirement savings and reduce their current taxes. Because of this, it is sometimes necessary to recast earnings. When you recast earnings, you adjust the earnings to reflect accrual methodologies or remove the impact of the additional expenses.

Recast

To recast is to cast anew or to reconstruct. When you recast earnings, you reconstruct your small business' earnings to appear as they would if the company was owned by investors and operated by professional management. This is sometimes necessary because many small businesses owners’ primary goal is to minimize taxes. Contrast this with public companies whose goal is to maximize profits and shareholder value.

Recast Reason

You may need to recast your company’s earnings when you prepare to sell your company or when you seek a valuation to buy out a co-owner or business partner. Another reason to recast earnings is to show a prospective investor or lender that your company is more profitable than it appears. In addition, if you do not use accounting software, you likely use the cash accounting method. A bank or other party may prefer to see financial statements using the accrual accounting method because of the additional information these provide.

Recast Items

Except for the conversion from cash to accrual accounting, the most common items that lead to recast earnings are your compensation as an owner and personal expenses the company pays including automobiles, insurance, phones, travel, meals and entertainment. Additional items include above market rent you have the company pay when you own your company's building and maximum contributions you make to Keoghs, SEP-IRAs or individual 401ks. If you keep accurate records of these items, it is relatively easy to recast the profit and loss statement. If you do not, you may need to hire a forensic accountant to dig deep and determine the additional expenses.

Example - Part 1

A hardwood floor installer company sought a $500,000 bank loan to finance business growth. The bank denied the loan. The company, which uses accrual accounting, only shows $50,000 in profit on $3 million in sales. The company's sole owner tells the bank the profits are much higher than he has shown the past three years. To prove this, he engages a CPA firm to recast his company's earnings.

Example – Part II

The owner provides American Express receipts, insurance bills and pay stubs showing how he brought his entire family with him on business trips, paid for his Mercedes and its insurance and employed his immediately family. These receipts total $150,000. He also provides receipts showing a $40,000 contribution to his SEP-IRA plus an additional $20,000 contribution for his wife. Adding back these expenses increases his company’s profits to $260,000.

About the Author

Tiffany C. Wright has been writing since 2007. She is a business owner, interim CEO and author of "Solving the Capital Equation: Financing Solutions for Small Businesses." Wright has helped companies obtain more than $31 million in financing. She holds a master's degree in finance and entrepreneurial management from the Wharton School of the University of Pennsylvania.